Don’t be surprised when unstable trades blow up: McGeever By Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) -One of the ironies of the burst of volatility that just blindsided financial markets is its inevitability.

Trades that are only feasible – and only highly profitable – in a world of low volatility are suddenly exposed when “vol” spikes. While traders can maintain these positions for a long time, they are inherently unstable, and getting the time right consistently is next to impossible.

These wagers include FX “carry trades” – considered by many to be central to the gyrations that have recently rocked world markets – and the so-called “basis” trade in U.S. Treasuries, where hedge funds arbitrage the tiny price difference between futures and bonds. 

Importantly, the leverage needed to juice the profits of many of these arbitrage trades amplifies the risk – and the pain when the inevitable turning point arrives.

In theory, none of these opportunities should last long if you believe in the efficiency of the free market, and its self-correcting ability to iron out arbitrage wrinkles once they appear. 

The reality is rather different, of course. 

Leveraged, speculative bets exploiting interest rate or price differentials can last for a remarkably long time. Witness the yen carry trade. It lasted for years, aided by a decade of “Abenomics” during which Japan deliberately weakened its currency with ultra-loose monetary policy. 

There’s nothing wrong with this, of course. Financial markets draw in participants of all guises with widely varying agendas, time horizons and risk tolerance profiles. 

But, as we saw recently, high-risk gambles can sour in the blink of an eye as selling to cover losses and meet margin calls begets more selling.

INTEREST RATE DIFFERENTIAL  

From a theoretical and fundamental perspective, such trades are often counterintuitive. 

Look at the FX carry trade. In its simplest form, this involves borrowing cheaply in a low-yielding currency and investing in a higher-yielding currency or asset. The trader pockets the interest rate differential and, in theory, the price divergence as the borrowed currency depreciates. 

But currencies that offer low returns are relatively low-risk assets backed by solid fundamentals like a big current account surplus. Interest rates are low because inflation is low.

Currencies offering higher rates of return are fundamentally less appealing. Yields are high to compensate for higher or more volatile inflation, increased credit risk, or greater…